Inflation – the double edged sword. Is a Recession just around the corner?

Inflation – the double edged sword. Is a Recession just around the corner?

Matthew Brown

Inflation – the double edged sword. Is a Recession just around the corner?

As a consumer driven society, we just want to earn more money so that we can buy more products and live a more lavish lifestyle. To earn more money, we need to charge more for our goods and services. By doing so, the price of goods and services rises, and it then costs us more. Hence, we need to earn more. This is the viscous cycle that has gripped society since the beginning of time.

With global economic growth slowing in 2014, and poised to slow a little bit more on the back of a third European Recession, slowing China, plummeting commodity prices and overabundance of Crude Oil, Australia’s growth for the coming year is looking a little sketchy. Without growth, the economy could slip into a Recession!

The Australian Consumer Price Index (CPI) data was released on Wednesday 28th Jan. This quarterly report reflects changes in the price of goods and services. In other words; Inflation. Inflation is defined as “a sustained increase in the general price level of goods and services in an economy, over a period of time”. As inflation rises, every dollar will buy a smaller percentage of a good or service.

Inflation is the reason why a loaf of bread may have cost only $2 a decade ago, but costs $4 now. For an economy to grow, it needs inflation. The problem arises when inflation is too high. If the costs of living rise too quickly, consumers will spend less, and this will slow the economy down.

Could the Reserve Bank of Australia reduce interest rates in the near future?

Heading into the release of the Australian CPI data on Wednesday, there was much speculation whether the results would show declining inflation, which could lead the Reserve Bank of Australia (RBA) to reducing Interest Rates in the near future. Lower interest rates help to stimulate the economy, while higher interest rates force consumers to spend less.

The numbers came in relatively stable at 0.2%. This was down from the previous quarter at 0.5%, and lower than the expected 0.3% analysts had been expecting. But what does it mean? Simply put, the price of goods and services is rising at 0.2% over the quarter. Therefore, Inflation, or growth, is very low at the moment.

Controlling Inflation through interest rates is the job of the RBA. Their mandate is to maintain inflation between 2% to 3% annually. This level is deemed to be sufficient for an economy to sustain itself without causing the cost of living to rise too quickly. Therefore, Wednesday’s figures are well below the target range. They would, in fact, be low enough to suggest that interest rates could be lowered further, especially if it were deemed that the economy needed stimulation. And at the moment, the debate over economic strength is leaning towards weakness in 2015 due to a slowing global commodity sector.

Could you imagine Inflation at 5,000%?

Not too long ago, in the late 1980’s/early 1990’s, Argentina suffered from an inflation rate of 5,000%. It is documented that prices were rising so fast that supermarkets would read prices out over the intercom rather than attempting to update price tags on the shelves. Such was the impact of an economy spiralling out of control.

By the turn of the century, Argentina saw its inflation decline to single digits, and the economy was on track as one of the strongest emerging markets. But this was short lived.

Inflation peaked at 40% in 2002 and is currently at 10.9%. This is still a phenomenal level that has a large proportion of the society living below the poverty line. And to think that Argentina is not too dissimilar to Australia in that they export a lot of natural minerals, have a diverse landscape, and were once a prosperous economy that fed the US and Asian countries.

Of course, several military coups over decades can be devastating to an economy. Something that would be unheard of happening in Australia.

Economic Stimulus … a necessary evil, or the catalyst for Armageddon?

America has spent the last two years with their central bank (the Federal Reserve), propping up the economy by pumping $85 billion per month into buying bonds. This is called Quantitative Easing (QE), and has been the difference between the Doom and Gloom of a collapsing stock market, and continued growth.

The European Central Bank (ECB) announced last week that they were starting their own QE, pumping 60 billion Euros per month into the economy. This figure exceeded most analysts expectations and triggered a small rally in the stock markets. It was short-lived with selling pressure returning in the last few days.

By buying up bonds, yields will decrease and this will entice companies/investors to borrow more. But yields are already at long-term lows and there is very little borrowing occurring in the EU. Only time will tell if this will work as well as the American QE program, which as mentioned, has taken a couple of years to play out.

In the end, however, all this debt needs to be paid back. Who is going to pay the piper in the end? Unless we have economic prosperity off the back of the stimulus measures, we may just be digging a deeper hole to climb out of.

Deflation is the real fear, and Australia has no protection against slipping into a Recession

Global fears right now are that deflation will start to trigger further declining global economic growth. While the ECB and Japan central banks are pursing QE, America and the UK are ending it. Deflation is the opposite to Inflation, which means a decrease in the general price of goods and services.

An economy cannot grow if cost of goods and services are declining. And that will only lead to a Recession, which can be defined as “a period of temporary economic decline during which trade and industrial activity are reduced”. It is typically measured as two consecutive quarters of negative economic growth, as measured by a country’s GDP (Gross Domestic Product).

While Australia has not seen negative GDP growth since 1992, the last half of 2014 did see a decrease in GDP growth rate on the back of falling commodity prices, decreasing exports, and rising unemployment. If China and the Eurozone continue to suffer from declining growth, this may have the impact that could lead to Australia slipping into a Recession.

For now, Australia is in a very low growth environment. Doom and Gloom is not on our doorsteps, not like it is in Greece, Spain or Portugal, but it is certainly on the minds of many. Now is the time to establish sound investment principles, and to take control of your investment capital. In particular, your Superannuation.

If you would like to hear more about how Inflation or Deflation is affecting our economy, we have an upcoming Create your own Income seminar in February, where we will discuss strategies to manage during stagnant economic markets. CLICK HERE to learn more.

Since 1998, Matthew has been involved in the Financial Services industry providing stock, option and CFD advisory services, trading advice, funds management and education services. Matt is an Authorised Representative of Halifax Investment Services, providing analysis and recommendations for trading Covered Calls in the US markets and using Exchange Traded Funds (ETFs) ...

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